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What Is A Financial Statement? Financial Statements In A Nutshell
Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.
The main financial statements are: Balance Sheet, Income Statement and Cash Flow Statement. Each of these statements has a different purpose and together they give us specific information in regard to: “Return, Risk and Cash”.
First, if you look at the income statement, there is no way you would make any assessment about the risk of the organization in that particular point in time or the cash produced in a certain period.
Instead, the Income Statement (or Profit & Loss) will show you the return generated by the business.
Second, if you want to understand how an organization acquired the resources to operate the business, you have to look at the Balance Sheet. How does the balance sheet assess the risk of an organization?
Simple: there are two ways a company can acquire resources, either through Equity or Debt. As you can imagine, too much debt can be dangerous. What would occur if you run a business and suddenly your creditors ask for the money you owe them?
You would go bankrupt. Instead, when debt in proportion to the equity is dismal, this makes your organization creditworthy and safer.
Third, it happened many times in the financial world history to see profitable companies bankrupted due to a poor cash management.
The cash flow statement helps you to answer questions such as: How much cash did we make? Where did the cash come from?
In fact, an organization can find cash through three main activities: Operating, Investing and Financing.
Income Statement (P&L): Show me The Bottom Line
The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).
The main purpose of the income statement is to show the return of the business in a certain period: Quarterly, Biannually or Yearly.
The income statement is built around the bottom line, the “net profit”. Do not be surprised to notice your eyes unexplainably falling on the net income.
This distracts you by other metrics on the Income Statement that are as important as the Net Income.
Balance Sheet: The Power Of The Now
The accounting equation is the fundamental equation that keeps together a balance sheet. Indeed, it states that assets always equal liability plus equity. The foundation of accounting is the double-entry system which assumes that a company balance sheet can be broken down in assets, and how they get sources (either though equity/capital or liability/debt).
The main purpose of the Balance Sheet is to show the risk of the business in the particular moment you are looking at it. In Fact, if you look at the balance sheet on January 1st it won’t be the same on January 2nd.
Of course, this is true for the P&L and CFS (Cash Flow Statement) as well, but the balance sheet is an instant snapshot of the business more than a collage of pictures taken in different moments, like the Income Statement.
Cash Flow Statement (CFS): Cash Is King
The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.
The main purpose of the cash flow statement is to show the cash generated by an organization in a certain period: Quarterly, Biannually or Yearly.
It doesn’t matter how much profits a business is making, one way to know whether the business will survive in the next future is to look at the cash.
Generating cash is not easy task and the organizations who are able to keep their profits stable and generate enough cash to sustain their operations and invest for future growth are the ones who thrive.
Real Life Analogy
Let me use a real life analogy here. If you are a photographer in order for you to do your job, you must have a professional camera.
In addition, you can take instant pictures or build a collage of pictures you have taken in the last three months, and remember the camera will work as soon as the battery will be charged.
Indeed, you can compare the single picture or “instant picture”, at your balance sheet, while the “collage” pictures taken in the last three months, at your income statement.
Furthermore, you want to see what’s the level of charge of the battery and how long the camera will operate. The battery life can be compared to your cash flow statement.
Indeed, a lack of cash for a business is almost like a lack of oxygen for an individual.
According to your needs you can look separately at each statement.
However, if you want the whole picture of the business you must look at all of them concurrently.
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